Heterogeneous Beliefs and Mispricing of Derivative Assets

In an exchange economy under uncertainty populated by multiple consumers, we how the heterogeneity in the individual consumers’ subjective beliefs affect the representative consumer’s utility function. We derive a formula that indicates that the more heterogeneous the individual consumers’ beliefs are, the higher probabilities the representative consumer’s belief attaches to extreme events that would, in the absence of heterogeneous beliefs, have very low probabilities. We also explore an implication of this formula on derivative asset pricing. JEL Classification Codes: D51, D53, D61, D81, D91, G12, G13.